The article analyses how government spending is determined under different
exchange rate regimes in the context of a small open economy. Assuming
nominal wage contracts which last for one period and assuming a benevolent
government which determines government spending to optimise a representative
individual’s utility, it is demonstrated that there are differences between
exchange rate regimes with respect to the level of government spending. These
differences arise first because a rise in government spending affects macroeconomic
variables differently under different exchange rate regimes, and second
because the government’s inclination to expand government spending is affected
by inflation which depends on the exchange rate regime. At low rates of inflation,
the government is inclined to set a higher level of government spending under a
fixed exchange rate regime than under a floating exchange rate regime in which
the monetary authority optimises preferences which include an employment target
and an inflation target. As government spending affects the representative
individual’s utility, the choice of exchange rate regime has an impact on welfare.
Keywords: exchange rate regimes; fiscal policy; monetary union; inflation
targeting.
JEL classicification: E42, E61, E62, F33.

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Kinks and jumps in the payoff function of option contracts prevent an effective
implementation of higher-order numerical approximation methods. Moreover, the
derivatives (the greeks) are not easily determined around such singularities, even with
standard lower-order methods. This paper suggests a transformation to turn the original
ill-conditioned pricing problem into a well-behaved numerical problem. For a
standard test case, both vanilla- and binary call price functions are approximated with
(tensor) B-splines of up to 10’th order. Polynomial convergence rates of orders up to
approximately 10 are obtained for prices as well as for first and second order derivatives
(delta and gamma). Unlike similar studies, numerical approximation errors are
measured both as weighted averages and in the supnorm over a state space including
time-to-maturities down to a split second.
KEYWORDS: Numerical option pricing, Transformed state spaces, Higher-order
B-splines.

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Housing markets in several countries are suffering. The prolonged and strong housing price rises of recent years have turned around. Historical records suggest that housing price drops may happen slowly but be large. Housing prices continue to fall because capital losses have substituted capital gains, housing equities are falling, and housing price expectations have become negative. Household debt had increased to the same degree as housing prices or even more in some countries. Access to mortgage and credit had improved and lenders used "cruise control” when financing still higher housing market prices. Now, housing demand is further weakened because access to credit has been tightened. During a downturn, owner-occupiers’ housing price risk is increased and a growing number of owners have negative equity and payment troubles. Under these conditions, arrears and foreclosures will be widespread in owner-occupation. The effects on the wider economy of a housing price downturn are discussed. Not only does the lenders’ increased credit risk lead to tightened credit access, losses threaten the banks and can create financial crises. Falling housing prices clearly depress the housing market and housing construction activities and thereby the contribution of residential investments to economic growth, while it is less obvious that average housing consumption and residential investments over the whole cycle are affected. The reduction of non-housing consumption as a result of a wealth effect is a reality for years for depressed owner-occupiers but in the aggregate, the housing wealth effect is more dubious.

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Abstract.
In Denmark, taxation of residential property returns varies considerably with the type of ownership and type of tenure in terms of the way income is calculated, the types of taxes applied and tax rates, which range from 0 % to above 60 %. Together with other housing subsidies this disparity in taxation contributes to the pronounced lack of tenure neutrality in the Danish housing market.
The paper illustrates how tax rules alone create distortions and imbalances in the housing and
residential property markets and discusses as well the magnitude of the imbalances. The method
used is the application of a set of return and user cost equations.
The tax aspects of the long-standing rather unequal treatment of private rental dwellings, social
rental dwellings, owner-occupied dwellings and private co-operative dwellings, which have drawn
decisive tracks in the markets, are discussed.
The lowering of the tax rate for the return of institutional pension savings to 15 % which came into effect in 2001 has created a substantial advantage for pension funds compared with private
investors with regard to investments in rental residential properties. The owner-occupiers’ user
costs and subsidization are shown to depend on their capital structure and to a large extent they
depend on whether the owners’ most obvious savings alternatives are either personal investments
with heavily taxed returns or institutional pension savings with lightly taxed returns.
Also private co-operative associations are tax exempted, and this fact in combination with the
prospects of improved legal conditions for raising loans to finance the individual apartments will
almost certainly lead to this form of tenure – as "tax free ownership" – capturing part of the
market for owner occupation.

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We consider a random utility extension of the fundamental Lucas (1978) equilibrium
asset pricing model. The resulting structural model leads naturally to a likelihood
function. We estimate the model using U.S. asset market data from 1871 to
2000, using both dividends and earnings as state variables. We find that current dividends
do not forecast future utility shocks, whereas current utility shocks do forecast
future dividends. The estimated structural model produces a sequence of predicted
utility shocks which provide better forecasts of future long-horizon stock market returns
than the classical dividend-price ratio.
KEYWORDS: Randomutility, asset pricing, maximumlikelihood, structuralmodel,
return predictability

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In this paper an investigation of the pricing of callable annuities with interest-only
(I-O) optionality is conducted. First the I-O optionality feature of callable annuities is
introduced. Next an algorithm for pricing callable annuities with I-O optionality using
the finite difference methodology, is formulated. This is then used to investigate optimal
strategies of I-O bonds and impacts on prices from the I-O optionality. It is found that
the I-O feature necessitates a simultaneous valuation of all elements of the callable I-O
bond. Following this, the Greeks of the I-O bond are investigated. It is found that they are affected by the I-O feature, but only to a limited extent. Finally, a model of heterogenous
prepayment decisions is incorporated into the framework. The model is extended to model
heterogeneity in the I-O exercise decisions. The incorporation of heterogeneity in borrower
decisions is found to lead to reasonable causalities.

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We describe the background and the basic funding mechanisms for the type of adjustable rate mortgage
loans that were introduced in the Danish market in 1996. Each loan is funded separately by tap issuing
pass-through mortgage bonds ("strict balance principle"). The novelty is a funding mechanism that uses
a roll-over strategy, where long term loans are funded by sequentially issuing short term pass-through
bonds, and the first issuer of these loans obtained a patent on the funding principles in 1999. Publicly
available descriptions of the principles leave an impression of very complicated numerical algorithms.
The algorithms described here show that the essentials can be reduced to a "back of an envelope" complexity.
Keywords: Adjustable rate mortgages, balance principle, patent, yield curve riding

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This paper investigates the pricing of step-up bonds, i.e. corporate
bonds with provisions stating that the coupon payments increase as the
credit rating level of the issuer declines. To assess the risk-neutral rating
transition probabilities necessary to price these bonds, we introduce a new
calibration method within the reduced-form rating-based model of Jarrow,
Lando, and Turnbull (1997). We also treat split ratings and adjust for
rating outlook. Step-up bonds have been issued in large amounts in the
European telecom sector, and we find that, through most of the sample,
step-up bonds issued by the two largest issuers have traded at a discount
relative to comparable fixed-coupon bonds from the same issuers. Our
findings cannot be attributed to traditional liquidity factors, and they suggest
that issuing step-up bonds increased the cost of capital for the issuers.
Keywords: defaultable bonds, step-up coupons, rating-based models
JEL classification: G12, G13